Why the Big Four provide higher quality audits

Ole-Kristian Hope, John Christian Langli, Limei Che

EY, KPMG, Deloitte and PwC give the best audits. Here's why.

Audited financial statements are important for capital markets and capital allocation decisions because auditing makes the information more reliable. Four international audit firms, known as the Big Four, dominate the global auditing market: EY, KPMG, Deloitte and PwC. Among listed firms (that is, firms listed on a stock exchange) in the EU and US, their combined market share is above 85 percent.

For decades, researchers have documented a “Big Four Effect” among listed firms, i.e. that Big Four audit firms provide audits of higher quality than non-Big Four audit firms. A variety of audit quality measures have been used and auditees of Big Four firms are associated with e.g., less earnings management, fewer restatements, lower cost of capital and better analyst forecast accuracy. In short, the results point to financial statements audited by Big Four firms being more reliable and accurate than financial statements audited by non-Big Four firms.

The Big Four Effect

Despite overwhelming evidence of a Big Four effect, very little is known about why such an effect exist. The explanations fall into three categories:

  • A self-selection effect among the auditees. It could be that client firms with the most reliable and accurate financial statements voluntarily choose a Big Four firm. Thus, the quality of their accounts are not affected by the audit, but they want their accounts to be approved by a Big Four firm. Therefore, it looks as though Big Four audit firms deliver higher audit quality, but the inference is invalid.
  • A hiring effect. Big Four firms could be better at attracting personnel that are more competent, better motivated and with higher innate abilities. If these persons worked in non-Big Four firms, they would have delivered audits of equally high audit quality as they do in the Big Four firms. But since they work in Big Four firms, it looks as though it is the audit firm that delivers higher quality, not the personnel.
  • A Big Four audit firm effect. The Big Four audit firms does something different than non-Big Four firms, for instance by having better audit methodologies and internal control systems which enhance the performance and quality of both staff and auditees. This the true audit firm effect because neither auditees nor partners would have been able to perform equally well if they were affiliated with a non-Big Four firm.

In most countries, it impossible to distinguish the audit firm effect from the hiring effect. Most auditor switches are also voluntary, making it difficult to eliminate the self-selection effect.  Using unique and confidential data from Norway, we were able to isolate the audit firm effect by keeping the pairs of clients and partners constant while varying their audit firm affiliation. Specifically, we analysed pairs of auditees and partners that switched from a non-Big Four firm to a Big Four firm.

For most of our client firms, these switches are not the contaminated by self-selection concerns because the switches occur due to mergers between non-Big Four and Big Four firms where almost all non-Big Four clients followed the switching partners. In supplementary analyses, we also analysed pairs of partners and clients that switched from a Big Four firm to a non-Big Four firm.

While numerous studies document a Big Four effect among listed firms, the evidence is mixed in the private firm segment of the audit market. That a firm is private means it is not listed on a stock exchange. We therefore start by testing and documenting a Big Four effect among private firms. After clients and partners switch to a Big Four firm, we document that audit reports modified for going concern uncertainty more accurately predict financial distress within the next 12 months; that fewer audit opinions are modified because auditee compliance increases, and that there is less earnings management.

These results are consistent with the partners being better able to accurately identify and evaluate financially troubled firms and provide a fair representation of the auditees’ financial situations in accordance with the regulation, resulting in less use of modified audit reports. Thus, audit quality increases after the switch. Since higher quality is likely to be priced, we also test and find that audit fee increase after the switch.

Better people, more learning, better incentives

More importantly than documenting a Big Four effect among private firms, we provide empirical evidence on three sources of the Big Four audit firm effect. Firstly, Big Four firms are better able to identify and recruit auditors in non-Big Four firms who already deliver higher-quality audits.

Before moving to the Big Four firm, the incoming partners provide higher-quality audit work and receive higher fees than partners who do not move up to Big Four firms. Importantly, even though the Big Four firms attract partners of higher quality, we document that these partners deliver even higher audit quality after the switch.

Secondly, Big Four firms emphasize learning, and provide better opportunities for learning. We show that the incoming partners spend significantly more hours on continuous professional education after the switch, consistent with increased learning. We also find that audit quality increases significantly more for the partners who switch to the largest Big Four offices. We attribute this result to increased learning because larger offices have more experts and peers to consult, which enables better learning.

Finally, Big Four firms are more stringent in monitoring and provide stronger incentives for high-quality work. For delayed filings of financial statements, an audit quality measure that only relates to monitoring and/or incentives (not learning), we document an immediate increase in audit quality.

Because we follow the same partner–auditee pair as they switch to Big Four firms, and because nothing has prevented the partner–auditee pair from filing in time before the switch, these partner–auditee pairs needed the Big Four effect to improve their timeliness. For audit quality measures that relates to learning, we document a gradual improvement, consistent with the fact that learning takes time.

In summary, auditors who switch from non-Big Four firms to Big Four firms are among the best in the non-Big Four market, and they become even better after joining a Big Four firm were they can benefit from the Big Four firms’ wealth of resources through enhanced learning and stronger incentives and monitoring.

Source: Limei Che, Ole-Kristian Hope, John Christian Langli (2020) How Big-4 Firms Improve Audit Quality. Management Science. https://doi.org/10.1287/mnsc.2019.3370


Published 27. August 2020

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